Taxation reform is a continuing and topical issue. With a new government and the need for budget repair I am reposting below an earlier article in the policy series by Michael Keating. John Menadue
Oliver Wendell Holmes, the great American jurist, is reputed to have said, ‘I like to pay taxes. In this way I buy civilisation.’ However, in contrast to Holmes’ noble ideal, too often today we hear people railing about the burden of taxation, as though it is in some way an unfortunate even illegitimate imposition upon ourselves, our economy, and our way of life.
Lower taxation has been embraced by all political parties without any evidence that, given our already low starting point, less taxation will in fact lead to higher economic growth, let alone pay for itself. Indeed there is no evidence that the advanced economies with high growth rates of per capita income have lower levels of taxation. Nor have past cuts in our income tax led to faster growth, such as when the top income tax rate was reduced from 60 per cent to 45 per cent.
So as John Howard put it when he was Prime Minister, tax cuts should be considered ‘after you have met all the necessary and socially desirable expenditures’ (my emphasis). And as I argued in previous articles (posted 6/4/2015 and 23/7/2014), all the evidence is that these expenditure demands, even if efficiently funded, are most unlikely to be fiscally sustainable without a modest increase in taxation relative to GDP.
Indeed Australia already has lower taxation than almost any other advanced nation, but we aim to provide the same level of public services and welfare as the others.
Thus the biggest challenge facing modern governments is the gap between expectations on them and their capacity to deliver. In these circumstances, encouraging unrealistic expectations of tax cuts is only making government more difficult.
In fact each of the major tax reform packages in 1985 and 2000 did not achieve any reduction in total taxation. Instead they were about changing the tax mix in favour of more efficiency, revenue protection and/or more equity. Although some tax rates were lowered – notably income tax to offset past bracket creep that had pushed more people into higher tax brackets – but these reform packages did not lead to any reduction in taxation overall.
Revenue Outlook
Projections in the Budget and the Intergenerational Report (IGR) show the ratio of Australian Government taxation revenue to GDP rising from 21.9 per cent in 2014-15 to an assumed maximum ratio of 23.9 per cent reached around 2020, and then maintained beyond. This 23.9 per cent ceiling for future taxation is the same on average as during the Howard Government years following their tax reforms starting in 2001-02.
Consequently if taxation revenue went back to where it was after the Howard Government’s tax reforms and before the GFC it would be about 2.0 percentage points higher than now. Furthermore, as I argued in yesterday’s blog on Fixing the Budget, restoring taxation revenue to this extent over the next few years would most likely be consistent with what needs to be done on the revenue side of the Budget to maintain long run fiscal sustainability. It would also be consistent with what the Government apparently regards as an acceptable level of taxation.
One significant difference, however, is that my proposals (below) do not rely on bracket creep as taxpayers move into higher tax brackets, whereas as much as 85 per cent of the increase in taxation revenue presently projected in the Budget relies on bracket creep.
The problem with this reliance by the Government on extra revenue through bracket creep is that according to the Treasury someone on full-time average earnings can expect to enter the second highest 37 per cent tax bracket in 2015-16 if the present income tax rate scale is maintained, and the average tax rate faced by such a taxpayer will have increased by 5 percentage points between 2013-14 and 2023-24. Furthermore, unchecked bracket creep in income taxes tends to be highly regressive, impacting more than proportionately on lower income earners.
As in the past, any government is therefore likely to want to provide future income tax cuts, at least sufficient to offset the impact of unchecked bracket creep. The Government itself recognises this and has promised lower taxes after the Budget returns to surplus. But this is not expected until sometime after 2020, and by then the Government will be relying on all of the extra revenue from bracket creep until that time. On the other hand if some of that extra revenue from bracket creep were returned to taxpayers through a reduction in income tax rates, then of course this would increases the amount of extra revenue or extra expenditure savings that would need to be found elsewhere.
Tax Reform Options
Accordingly it is necessary to consider the alternatives to this reliance by the Government on bracket creep to boost its income tax receipts. Instead I propose to consider the options for another round of tax reform, but especially having regard for the present deficit budget outlook and future expenditure demands, and the consequent need to raise more revenue both at the Commonwealth and State levels of government.
Strategically there are three broad approaches in these circumstances to taxation reform:
- Broadening taxes
- Adjusting the mix of taxes
- Changing the tax rates
Typically tax reform involves a balanced mix of all three approaches. The task is to convince the public that the outcome is a more efficient system, especially in terms of its economic impact, that will raise the revenue that is necessary, but not more than necessary, and that it is fair.
Retaining company tax and broadening taxes
Judged against these criteria it is suggested that the best options to start with would be to:
- Not cut the company tax
- Broaden the tax base
Despite the lobbying by the business community, there is no need to cut the company tax rate. This would mainly advantage foreign investors, but the evidence is that Australia has no difficulty in attracting foreign investment. Instead, because of dividend imputation a cut in company tax would lead to lower imputation credits, and not benefit Australian investors much; indeed it could disadvantage Australian investors if it was financed in part by removing dividend imputation.
In a previous posting (22/7/2014) I discussed the possibilities for broadening the tax base. In brief, the possibilities that would seem to have the most positive impact as well as raising extra revenues are
- Reducing the favourable taxation of superannuation. The present tax concessions are more than necessary to encourage this form of savings for retirement, and they are inequitable, with more than half their value accruing to the top 20 per cent of income earners.
- Removing the 50 per cent capital gains discount. This discount is a distortion and its removal would help improve the efficiency of the housing market in particular, and make homes more affordable to new home buyers. Some commentators have similarly argued that negative gearing should no longer be allowed under the income tax, but strictly this is not a distortion because interest is a normal deduction before deriving taxable income.
- Restoring carbon pricing which is the most efficient and effective way of reducing carbon emissions and the risk of climate change.
- Removing the tax credit for fuel excise and increasing that excise. There is no economic case for subsidising one type of input to only some producers. Indeed it would be better to encourage greater fuel efficiency by increasing its price over time, up to say the price levels in New Zealand, and then fully indexing the excise rate.
- Improving the anti-avoidance measures. The Government is proposing some such action in this Budget, but much more needs to be done and can be done to protect the revenue.
A rough estimate is that these measures would increase annual tax revenues by around $29 billion when fully implemented; that is equivalent to filling the remaining gap of around 1.5 per cent of GDP that is needed to ensure ongoing fiscal sustainability after allowing for the expenditure savings identified in yesterday’s article on Fixing the Budget.
Changing the tax mix in favour of more reliance on the GST
The other major possibility for base broadening which would increase the revenue substantially is the GST. The proceeds, however, of the GST accrue entirely to the States, and so they cannot be used directly to improve the Federal Budget. Nevertheless, if these extra GST transfers were used to offset reductions in some other payments by the Australian Government to the States, then such an increase in the GST could help restore and maintain Australia’s fiscal sustainability over time.
The implications of such a strategy based on an increase in GST revenue will mainly be discussed in tomorrow’s article on Federalism. Suffice to say here that the coverage of the GST is now only 47 per cent of total consumption, down from a peak in 2005-06 of 56 per cent, which was close to the OECD average, but much less than in New Zealand where 96 per cent of consumption is taxed.
If the GST base were broadened to include expenditures on food, child care, private health and private education, and water, sewerage and drainage, the total GST revenue would be roughly doubled raising revenue by more than $50 billion extra each year. While an increase in the tax rate from the present 10 per cent to 15 per cent on the present GST base would raise around another $25 billion each year, and on the extended base it would raise around another $100 billion annually.
The experience of the Howard Government, however, when it first introduced the GST was that a very large part of the proceeds were used to compensate lower to middle income families who were deemed to be disproportionately disadvantaged by the new tax. If that precedent continued to apply it might be prudent to assume as much as one third of the extra revenue would be needed for this purpose and not available to improve long-run fiscal sustainability. Indeed if the GST base were broadened as described above to include expenditures on food, health and education that are regarded as essential, then the pressures for compensation might be even greater[1].
Of course less substantial changes in the GST could readily be contemplated. The size of the package would probably depend mainly upon what is the preferred basis for future Federal-State financial relations and the overall governance arrangements for the Australian nation. As already indicated these issues will be explored in tomorrow’s article, but even if no substantial change in our federal-state financial relations is envisaged, a modest package of GST reforms to increase the revenue would be a good option if the other policy changes already canvassed do not prove sufficient to ensure on-going fiscal sustainability in the long run.
Increase in the income tax rates
As noted the income tax rates will effectively increase over time if nothing is done because of bracket creep as incomes rise and tax payers move up the rate scale. But this is an arbitrary and unfair way of raising additional revenue if that were needed. Instead in that case it would be better as a matter of deliberate decision to introduce a new income tax rate scale. Such a new rate scale could at least maintain the present progressitivity of the income tax rather than letting it degrade in an arbitrary way.
A further consideration is the overall tax mix. Many argue that Australia is too dependent on the taxation of income and that there should be more reliance on taxation of expenditure. In fact if we allow for various forms of compulsory social security contributions plus payroll taxes then direct taxes in Australia comprise around 63 per cent of total taxation compared to an OECD average of 61 per cent. This suggests that the present balance between direct and indirect taxation in Australia may well be sustainable. Nevertheless if additional revenue is needed to ensure long-run fiscal sustainability then it would be prudent to consider the options for increasing the GST before an increase in income tax rates.
Dr Michael Keating AC was formerly Secretary of the Department of Finance, and Secretary of the Department of Prime Minister and Cabinet.
[1] Ac
Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations. He is presently a visiting fellow at the Australian National University.
Comments
2 responses to “MICHAEL KEATING. Taxation Reform”
When he wrote this article, Dr Keating must have known he was speaking of an appropriate tax system in an ideal Australia rather than one that the current major political parties might be likely to support or he would not have suggested an increase in income tax. Such a move would be tantamount to political suicide in the real Australia of today. So, while he was considering the various tax options, I’m surprised that he didn’t take the opportunity to float the possibility of some other possible tax measures that, although unattractive to politicians interested in re-election, deserve a place in an ideal system.
I have some suggestions. With the growing problem of inequality in mind, there is a strong case to be made for inheritance and gift taxes to be in the tax mix. Also, a “Tobin” tax on currency transactions and a small securities transactions tax might help curb speculative stock market gambling while raising revenue. The other very desirable federal tax is a tax on land. This would not only be a Pareto efficient tax but one that would be easy to collect as it could be piggybacked onto local government rates. And while he is happy to talk about increasing the GST, which goes to the States, he fails to point out some of the other more egregious State taxes whose removal could potentially be offset by reductions in some other payments by the Federal Government to the States. Payroll taxes and stamp duties fall into this category.
Nevertheless, I agree with his article except for his support for an increase to and broadening of the GST. This tax is inherently regressive at all income levels. You can compensate low income earners but the fact remains that middle-income earners and even the very well off will end up paying a higher percentage of their income in GST than the rich. A GST, especially one on food, simply transfers the burden of taxation from higher income earners to lower income earners. Moreover, there is never a guarantee that compensation will not fade away over time. It is also less than smart to devise a tax and then have to give back a third or more of it.
However, these criticisms do not detract from the big message, namely, that the best way to restore the budget to balance is to raise income tax revenue. Rather than just changing rates for the existing brackets, the whole income tax system needs reworking. Instead of a few brackets, there should be either many brackets or, even better, a continuous scale.
Much has been written about how an increase in income tax rates would discourage people from working. Theoretically, a tax rate of 100% would stop all people from working and a tax rate of zero would stop none. But it is not that simple and it is certainly not a linear graph. Many attempts to decide what an “optimal” tax level for a high income earner would be that would raise the revenue without discouraging work. Emmanuel Saez theorised that the top marginal tax rate which would not distort decisions to work would be between 50 and 80 percent. This would seem to provide plenty of space for increases to upper-level taxation in Australia. There are certainly many nations in the world with much higher top marginal rates which don’t have a problem of the rich withdrawing their labour.
There are several other factors worth noting. One is that the spread of wages has greatly increased in Australia in recent decades. This does not so much recognise growing productivity of earners at the top end but, rather, that the labour market at the top has become very imperfect. Laws of supply and demand for labour don’t work at the top. CEOs of big companies are paid hundreds of times what the lowliest worker receives, not because they are worth it but because they and their boards are part of a cosy group who look after each other at the expense of everyone else. They would still be miles ahead of everyone else and not likely to resign if their pay was only half what it is now. We know this because there was no shortage of CEOs when the pay actually was half what it is now. There was also no shortage of CEOs when the top marginal rate was 60%. Another factor is that of marginal utility. A poor person who spends all of her take home pay suffers badly if their tax increases. A rich person might notice but will not change their living and buying habits. A third factor is that people don’t only work for money. Many if not most workers, and high-income earners especially, also work for job satisfaction. At the top level they enjoy being at the top of the pile where they give the orders rather than receiving them. Rupert Murdoch still works in his eighties even though he could not spend all his great wealth in a hundred lifetimes.
Its also said that tax increases will drive the rich to avoid or evade their taxes. The answer to this is to improve the legislative structure to close loopholes and to increase policing. It is not a reason to give them a tax break. Some people also argue that our income tax system needs to be competitive which that of other countries. There does not appear to be any good evidence for this idea. Apart from the fact that we already have almost the lowest overall tax rate of any developed nation, Australia has a lot of other attractions for potential workers beyond our tax rates. Furthermore, the Scandinavian countries with much higher tax rates don’t seem to have a problem from being “uncompetitive”.
Finally, it is sometimes said that there has to be a balance between efficiency and equity. I do not accept that these desirable aims need to be in conflict. If there ever is a conflict, equity and fairness should always trump both efficiency or ease of collection.
I have never understood how we expect the economy – and indeed society – to flourish by taxing people who work, taxing those who employ others and then taxing them all when they spend. Greater emphasis and reliance should be placed on other ways of raising revenue but The Tobin Tax, Transaction Taxes and Land Value Taxes all get scant consideration because the present system does suit the wealthy/influential sector. My favourite for greater us would be Land Value Taxation.
Land Value Tax can raise revenue and reduce problems of fairness, housing affordability and under-utilisation of land. But there are a few subtleties often overlooked about LVT – Land Value Tax.
1. The ‘best-designed’ property tax is the simplest – a flat-rate levy on the unimproved value of the land with no – or very few – exceptions.
2. The moral justification for such a tax is that if you wish to have a piece of Australia for your exclusive use and benefit, then you compensate us for foregoing that amenity, after all, it is ‘our’ land.
3. A land value tax (LVT) converts the costs of useful infrastructure from expenditure to investment. Such infrastructure always enhances land values and a LVT would ensure that this would be reflected in enhanced Government revenue – indefinitely – instead of a capital gain for the property owner.
4. Conversely, any property owner suffering a loss in value would be automatically compensated by a reduced LVT obligation.
5. It is fit and proper that the greater the value of the land, the more you will pay ‘us’ because it is our efforts and facilities – that is, the society’s – that give and maintain the value to your asset. The value of a parcel of land depends on the community services that it enjoys by way of defence, policing, transport services, educated manpower, health and recreational facilities.
6. Because the ‘big end of town’ generally owns a lot of property a flat rate tax would see them pay their proper share towards these community services.
7. By increasing the cost of keeping blocks undeveloped and houses empty, a LVT would reduce speculation in property ownership and stabilise house and land prices; in the longer term, housing would become more affordable – the opposite of present prospects.
8. Federal Government leadership could see pressure being applied to the States to adopt a nationally uniform, flat-rate LVT; if they can be pressured into selling income-producing assets, the States could surely be ‘encouraged’ to make full use of their land taxing rights.
9. That all the valuation and collection systems for a simple, flat-rate LVT are in existence – and that the tax liability cannot be shifted off-shore or be denied are more compelling reasons for LVT to be a priority consideration.
10. A unique feature of LVT is that it is in a sense voluntary! If the LVT you are asked to pay does not equate to the value and amenity that you enjoy from the property, then you can get someone else to pay it – by moving elsewhere. Not easy but entirely legitimate!
An ideal scheme would be to start with a very small, nationally uniform, LVT with a planned regular increase so that the land and housing markets have a certain and definite path to transition. In due time, GST could be eliminated and Stamp Duty too.
Unfortunately, ‘the big end of town’ does not want to pay their proper share and often cite the aging widow who – through no fault of her own – has become asset rich and income poor. How could she cope with a LVT? A solution would be for a Reserve Bank Land Trust to buy her freehold at valuation and for her to live out her days as a totally secure leaseholder – financially well-endowed and surrounded by her newly adoring grandchildren!